The Dark Side of the Bankruptcy Decline

Preference claims can sneak up on companies when they least expect it.
Marie LeoneAugust 27, 2007

The numerical news from the corporate bankruptcy front has been relatively good. Since 2003, the number of businesses filing for bankruptcy has dropped by 36 percentage points, finishing at 23,887 for the year ending June 30, 2007. That’s 24 percentage points below last year’s total for the same time period. But the reported numbers don’t tell the whole story. What’s missing is the tally for preference claims, the lawsuits filed by trustees of bankrupt companies against the ailing company’s vendors — the suppliers that tend to be unsecured trade creditors.

Governed by the U.S. Bankruptcy Code, preference claims are meant to prevent an insolvent company from favoring one creditor at the expense of another. Basically, the bankrupt company has the right to sue vendors to force them to return payments that were made within 90 days of the bankruptcy filing. While the law’s rationale may not make immediate sense, its aim is clear. Its purpose is to stop failing companies from doling out payments to preferred vendors just before they go broke.

The number of preference claims on bankruptcy-court dockets, however, is hard to estimate because the courts don’t identify the suits per se. But attorney A. Dennis Terrell, a bankruptcy-practice partner at Drinker Biddle & Reath, reckons that preference suits can number as few as 30 for small-company bankruptcies or as many as 10,000 for the multi-billion-dollar insolvencies.

Unfortunately for creditors, preference claims represent a double whammy. First, vendors lose a customer to bankruptcy. Then, they must defend against a lawsuit that aims to grab back any recent payments the insolvent company may have made. More troubling, because of the protracted nature of most preference claims, the suit often takes a company by surprise. Preference claims are usually launched two years after the initial bankruptcy is filed—just before the preference claim statute of limitation expires.

Thus, the preference claims creditors will see this year are likely to be associated with Chapter 11 petitions and Chapter 7 liquidations filed in the second half of 2005, as well as 2006. That list includes some big cases, including Delta Airlines, Northwest Airlines, Tower Automotive, Meridian, and Delphi.

The vendors hit with the greatest number of claims tend to be in industries suffering through a downturn, such as perennials like the airline, auto, and subprime-mortgage sectors. Companies that do business across many sectors, such as telecoms and computer companies, are also likely to absorb many preference claims. “It’s not that they are in a lousy industry, it’s just that they do business in every industry,” says Hal Schaeffer, president of D&H Credit Services, a trade-credit-analysis firm that specializes in preference-claims research.

While both large and small companies have been besieged by trustees looking to collect preferential payments, Schaeffer predicts that smaller companies will be more of a target over the next few years. That’s because law firms that hired preference-claims specialists during the early part of the decade – when the Internet bubble burst and corporate scandals produced record-breaking bankruptcies – are now trolling for business because the number of filings are down. That means plaintiffs’ attorneys are searching for business—and are thus apt going after claims as low as $10,000, Schaeffer says.

Small companies with diminutive legal teams are, at the same time, likely to feel the pain a whole lot more than big companies are. Once the claim is launched, a vendor can be tied up in court or mediation for years. For instance, several preference claims against creditors of Enron, which filed for bankruptcy in 2001, remain unresolved. The same is true for suits brought by the trustees of retail chain Service Merchandise and lawn equipment maker Murray Inc., which filed for bankruptcy in 1999 and 2004, respectively, says John Rowland, a partner in the bankruptcy practice of Baker Donelson Bearman Caldwell & Berkowitz who is involved in the cases.

Rowland represented 60 preference claimants in the $3.7 billion bankruptcy of Service Merchandise and 30 claimants in the Murray case. Murray’s assets were eventually sold to Briggs and Stratton for $150 million in 2004. Rowland didn’t divulge the total number of preference claims related to each of those cases. But most often, the tally grows in direct relation to the number of creditors that can be dogged for payment.

Consider that when Bethlehem Steel filed for Chapter 11 protection in 2001, it had recorder $2.6 billion in revenues for the first nine months of that year. On the heels of the bankruptcy, 6,000 preference actions were filed, says Terrell, who represents the steel maker’s retirement committee. The committee, one of the beneficiaries overseeing payments to retirees, is Bethlehem Steel’s second largest creditor—trailing only the Pension Benefit Guaranty Corporation. So far, retirees have gotten two payouts from Bethlehem Steel, which eventually had to liquidate its assets after a merger deal aimed at pulling the company out of bankruptcy fell through. Terrell says the trustees “envision” two more payments for retirees—and some of that money will be collected via preference payments.

Despite the potential flood of preference suits, there is one bright spot for vendors. The new amendments to U.S. bankruptcy law will make it “easier to defend against these actions,” contends Terrell. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 (BAPCP) lessened the burden of proof for companies defending against preference claims.

Take the often-used “ordinary course” defense. Under the old law, to prove that a payment wasn’t preferential, the creditor had to establish two things: that the payment was made during the ordinary course of business and on terms considered standard in the debtor’s industry. The new law, however, says the vendor only has to prove one or the other conditions.

Although it usually requires third-party verification from an industry expert or research firm, proving that the payment was made under typical industry terms can be a relatively straightforward task in court. An expert may, for example, verify that within the perishable-food industry a net seven days payment term is typical, while the jewelry sector works on a net 360 days schedule.

On the other hand, no experts are needed to establish that a payment was made in the ordinary course of business. While that can be researched in-house, the task will keep the billing and receivables departments busy. To mount an ordinary-course defense, the vendor has to prove that the credit terms extended to the insolvent company are consistent with the way the two entities generally conduct business. That proof can come in the form of invoices, correspondence, and other documents.

Schaeffer believes that while in most cases a defendant needs at least two years worth of material to build a solid case, some judges require less evidence. Collecting such information is easier for some companies than others. He cites clients that have slogged through 50 or more different computer systems and a warehouse full of documents to make their case. But the payoff is usually worth the effort in big cases. For example, spending $5 million to build a defense may be a better investment than paying a $20 million claim, adds Schaeffer.

The 2005 bankruptcy act also set a new threshold for launching suits, eliminating those involving below $5,474 in claims. (The level, which started at $5000 in 2005, is tied to inflation and adjusted annually). No claim-amount curbs existed before the new law. Further, for claims of $10,950 or lower, the suit can be heard in the state where the creditor resides, rather than where the bankruptcy case is filed. This provision eliminates venue shopping and allows creditors to defend smaller claims in their home state. “It’s good to see the limit changes in place,” comments Rowland. By his lights, “it is difficult to litigate any claims that are below the $25,000 threshold because of [legal] fees.”

Rowland points to another plus for trade creditors: a move toward more mediation. Rowland says that 80 percent to 90 percent of preference actions are settle in the mediation stage or shortly thereafter. He says that in some cases, avoiding a judge’s ruling offers bankruptcy trustees a faster settlement that can sometimes have a higher recovery rate and holds down defendant legal fees. The key to successful mediation is just getting all the parties in the same room, adds Rowland. “Cooler heads prevail [in mediation] than in court.”

Schaeffer has some tips for vendors, noting that some well-structured defenses have reduced claims to 10 cents on the dollar. As previously reported, two ways to prevent preference claims are to ask for cash on delivery and payment in advance. Both types of payments are exempt from the preference law provision of the bankruptcy code. Creditors can also argue that the debtor was still solvent when the payment was made. Conducting a solvency analysis is “difficult and expensive,” warns Schaeffer, but he says it was used successfully by a vendor that reduced its Enron-related claim from $500,000 to zero.

Industry idiosyncrasies also provide some unique preference claim defenses. In the construction sector, the federal Miller Act may shield subcontractors from preference suits by wiping out the notion that an insolvent prime contractor showed preferential treatment to subcontractors.

Under the act, the government requires prime contractors to post surety bonds, one of which is designated to pay off subcontractors if the main contractor goes bust. The bonds assure the government that it won’t be left holding the bag if its general contractor goes out of business. But the bond, not the insolvent company, pays the subcontractors. That means that the subcontractor would not have been shown preferential treatment by the bankrupt company and could not have been paid at the expense of other creditors.

Similarly, the advertising industry can use the “conduit” defense to avoid the full brunt of preference claims suits. Ad agencies regularly make media buys for clients, funneling money from the client to outlets. The agencies tend to retain only account-management and creative-service fees and pass through the rest of the payment to the outlets. But defunct ad buyers have been known to sue their agencies for the entire payment. That was the case when one bankrupt client sued its ad agency for $3.2 million in preference claims, according to Schaeffer. The claim was eventually reduced to $20,000, mainly because the ad agency could argue that it was merely a conduit for the payments to the media outlets, he says.

Unfortunately for vendors, there are no rules of thumb for defending against preference claim actions, says Schaeffer. The claims are case specific, and usually valid, because plaintiff’s attorneys and the trustees that they represent scan the books of the insolvent company looking for any payments made within 90 days of the bankruptcy filing. Then the question becomes, “do you have a defense,” the lawyer says, “and how creative can you be with that defense.”